Investing

What Michael Lewis Gets Wrong About High-Frequency Trading

(Correction: A previous version of this story said E*Trade was a large wholesaler of retail stock orders. E*Trade sold its market making unit in October 2013. )

Michael Lewis spent the first half of Tuesday promoting his book about high-frequency trading on NBC. In the morning, he went on NBC’s Today show. By midday he was on CNBC, taking in part in a battle royal over the merits of HFT. Lewis’s TV publicity tour started on Sunday night with an appearance on 60 Minutes.

Lewis’s book, Flash Boys, is driving a huge amount of attention toward the topic of high frequency trading, and it has rekindled some of basic arguments over its impact on markets and investors. The new book is typical Lewis. It’s a page-turner that reads like a novel and succeeds in making complex topics accessible to non-experts. By taking seemingly disparate developments—the secretive race to build underground, super-fast fiber optic cables, the 2009 arrest of a Goldman Sachs computer programmer—Lewis stitches together a compelling, character-driven narrative to walk readers through the immense changes the financial markets have undergone over the past decade.

Still, the book fails in some big ways, mostly due to Lewis’s zeal to simplify complex subjects into catchy bites and to consign players to clearly heroic or villainous roles. Here are three things Lewis gets wrong:

1. HFT doesn’t prey on small mom-and-pop investors. In his first two TV appearances, Lewis stuck to a simple pitch: Speed traders have rigged the stock market, and the biggest losers are average, middle-class retail investors—exactly the kind of people who watch 60 Minutes and the Today show. It’s “the guy sitting at his ETrade (ETFC) account,” Lewis told Matt Lauer. The way Lewis sees it, speed traders prey on retail investors by “trading against people who don’t know the market.”

The idea that retail investors are losing out to sophisticated speed traders is an old claim in the debate over HFT, and it’s pretty much been discredited. Speed traders aren’t competing against the ETrade guy, they’re competing with each other to fill the ETrade guy’s order. While Lewis does an admirable job in the book of burrowing into the ridiculously complicated system of how orders get routed, he misses badly by making this assumption.

The majority of retail orders never see the light of a public exchange. Instead, they’re mostly filled internally by large wholesalers; among the biggest are UBS (UBS), Citadel, KCG (KCG) (formerly Knight Capital Group), and Citigroup (C). These firms’ algorithms compete with each other to capture those orders and match them internally. That way, they don’t have to pay fees for sending them to one of the public exchanges, which in turn saves money for the retail investor. For a detailed map of the market’s plumbing and how orders get filled, check out this Bloomberg Businessweek graphic from 2012.

Many retail investors enter the market through buy-side institutional investment firms such as pension and mutual funds. Lewis contends that these big, slow traders are also getting screwed by HFT. While that certainly might have been the case a decade ago, they caught up years ago. Talk to most chief investment officers at these big firms today and you’re more likely to hear how efficient trading is today, compared to 20 years ago—back in the era when orders got routed through human market-makers standing on the floors of exchanges.

Last year, I spoke with Gus Sauter, the former chief investment officer at Vanguard, one of the biggest buy-side investment firms in the U.S. By the time he retired in 2012, he had about $1.75 trillion under his watch. Rather than decrying speed traders, Sauter praised the benefits it had brought to him and his clients. By his estimate, speed traders helped him save him more than a $1 billion a year.

2. Speed trading isn’t hugely profitable. Lewis gives the impression that high-frequency trading firms are rolling in dough. The reality, however, is that HFT’s best days are behind it, and many firms are barely keeping their heads above water. Getco, which merged with Knight and was once a titan of HFT, experienced a profit drop of 90 percent in 2012. That year, according to estimates from Rosenblatt Securities, the entire speed-trading industry made about $1 billion, down from its peak of around $5 billion in 2009. That’s nothing to sneeze at, but it isn’t impressive once you put it into context: JPMorgan Chase (JPM) made more than $5 billion in profit in just the last quarter.

Halfway through Flash Boys, Lewis writes that “financial intermediaries” made $10 billion to $22 billion a year. While he doesn’t define the term, he gives the impression that he’s talking about HFT firms serving as electronic market-makers, matching up buyers and sellers and profiting off the spread, which is rarely more than a penny per share these days. Pre-HFT, it used to be around 12¢.

Lewis doesn’t say where he got those estimates. To the firms that track HFT profits, the figures seem wildly inflated. Tabb Group also estimates HFT profits, and its latest figures show that industrywide profits are about $1.3 billion, down from a peak of about $7.9 billion in 2009.

3. High frequency traders aren’t Wall Street Insiders. One of the staples of a Michael Lewis book is a narrative of outsiders disrupting an entrenched system and knocking down established ways of doing business. Moneyball features Oakland A’s general manager Billy Beane. The Big Short focuses on investor Michael Burry. In Flash Boys it’s a group of former traders at Royal Bank of Canada (RY:CN) who go on to form their own exchange.

By focusing on this story, Lewis misses the much bigger tale of disruption that speed-trading firms themselves brought about over the past 15 years. Hardly a group of typical Wall Street old-boy, big-bank types, many HFT ventures are the consummate outsiders. Such firms as Tower, Hudson River Trading, and ATD were started by tech geeks who figured out a better, more efficient way to trade. Their first victims weren’t mom-and-pop traders but big, established, market-making firms that made up the clubby insiders’ group of floor specialists.

This is not to say that Lewis’s book has no merit, or that the market isn’t messed up right now. Lewis puts his finger on a lot of what’s wrong: The competition regulators hoped to induce through new rules over the past decade has led to a fragmented market rife with perverse incentives and far too much complexity. Speed traders have certainly benefited from the new ecosystem, and there are undoubtedly bad actors among them. But it’s too much to say that as a whole, they’ve rigged the market. Vilifying them misses the bigger picture.